Chart of Berlusconi: Dire Arrivederci alla Dolce Vita (Guest Post)

By Eric Schaefer

For a moment there, it seemed that Silvio Berlusconi, the Italian Prime Minister, was one lucky man.

Just as it seemed as if an end had finally been scripted for the ongoing Greek sovereign debt tragedy, allowing the European Union to focus on Italy and its debt problem, Georgios Papandreou, the Greek Prime Minister, added a new act to the drama. By calling for a referendum on the austerity package his government negotiated, Papandreou's move shifted the spotlight briefly from Italy back onto Greece.

Of course, there is consternation in Brussels, Berlin and Paris concerning the sudden need to provide the average Athenian with a say in the matter. Now, Berlusconi is no stranger to consternation: he is a past master at turning it to his advantage. But this time he may not be able to perform a sleight of hand. Chancellor Merkel and President Sarkozy are in no mood for the further antics of politicians from the Mediterranean. He must forge a deal to keep Merkel and Sarkozy from adding to the chorus of criticism of his government.

The problem is not the magnitude of Italy's debt or the size of its deficit. The problem is the Italian parliament's inability to reach a consensus on fiscal reform — in particular, on pruning Italy's expensive welfare state. Adding to the urgency is the degree to which Italy's economy and financial markets have become integrated within the EU. While a Greek exit from the Euro can be contemplated, Italy's departure cannot.

At the end of 2010, Italy's central government debt to gross domestic product (GDP) was 127 percent (compared to 147 percent for Greece). The central government's budget deficit is projected at a modest 3.9 percent (of GDP) for 2011 and 2.6 percent for 2012. Nor is the country's net international investment position (IIP) alarming. Italians at the end of the 1st quarter had more foreign liabilities to assets, totaling 26 percent of GDP. In comparison, Greece has a negative IIP of 101 percent (of GDP).

Here is where the differences end. Italy, like Greece, is dependent on foreign sources to finance its budget deficit. Using Banca d'Italia data, we estimate foreigners financed €798 Billion of €1.5 Trillion in government debt as of 2009. In part, this reflects a domestic imbalance. But, it is also a reflection of the benefits currency integration has brought to Italy and other Euro nations. A common currency enabled portfolio shifts difficult to effect with 17 different currencies. Risk-adverse northerners can now buy comparatively safer government debt, while Italians can earn more on their savings by lending for productive uses such as business investment. All benefit from the expanded opportunity set.

The cost: integration reduces the room for maneuver in a crisis. Sorting out the spaghetti of capital flows is well nigh impossible. Perhaps it is time for Berlusconi to say Arrivederci to La Dolce Vita.